NEW YORK (Reuters) - Reinstating a rule designed to slow the pace of short selling could help calm volatile markets, preventing already battered stocks from snowballing further.
Short selling, where an investor bets on a declining share price, has come under increased scrutiny, with opponents arguing it has exacerbated the sharp losses seen since the onset of the global credit and economic crisis.
Bringing back the uptick rule, which would only allow short sales when the last sale price is higher than the previous one, would stem a stock’s decline by preventing short sellers from piling on one after another, market-watchers said.
U.S. Rep. Barney Frank, chairman of the House Financial Services Committee, said on Tuesday that he expects the Securities and Exchange Commission will restore the rule in about a month.
His comments added strength to a rally in U.S. stock markets, pushing the broad S&P 500 .SPX up more than 5 percent.
Critics say banks have been especially hurt by short sellers betting their stocks have further to fall, serving to drive the shares down more than warranted.
“If there’s no uptick rule, the short selling can become overwhelming,” said Bill Rhodes, founder and chief investment strategist at Rhodes Analytics in Boston.
“When you get a tidal wave of pessimism, everybody wants to short, and what the uptick rule does is it creates a queue so you have to get in a line to do it.”
The SEC repealed the uptick rule in 2007 because the agency found that changes in trading strategies made it ineffective.
Since then, the world economy has unraveled as massive bank losses and write-downs have pummeled confidence and changed the landscape of the financial system; shares of major banks such as Bank of America (BAC.N) have fallen to single digits and Citigroup (C.N) has traded below $1.
Federal Reserve Chairman Ben Bernanke has said in Congressional testimony that the SEC was looking at restoring the rule and that the measure might have had some benefit if it had been in effect in the current crisis.
“I believe that what happened is a lot of things have been done the last few years which are fine for stable markets, but the real test comes when markets are unstable,” said Subodh Kumar, chief investment strategist at Subodh Kumar & Associates in Toronto.
“Taking out the uptick rule during a time of stress exacerbates things.”
Following the collapse of Lehman Brothers and the government bailout of American International Group (AIG.N), some pundits and corporate executives blamed the market turmoil on short selling, a process which involves selling a borrowed stock in the hopes of buying it back at a cheaper price.
Regulators responded by imposing a temporary ban on shorting financial stocks in late September, but markets continued to dive.
That proves that imposing such rules have no effect on prices, said Scott Jacobson, chief investment strategist at Capstone Sales Advisors, in New York, who said the uptick rule would not calm markets as it would create an “artificial friction.”
“Let’s just say that the short seller is correct and the price should be lower. If you prevent that price from going lower through some artificial means, it will have to go there at some point in the future,” said Jacobson.
Whether bringing back the rule would help, analysts said the discussion by prominent policy makers signals it is not something to be taken lightly.
“Bernanke is a person who’s very careful with his words. On top of that, central bankers are known for being relatively obtuse for good reason,” said Kumar, who favors reinstating the rule.
“So when we put those two things together, and he specifically says that it is something to look at, in my opinion, that’s more than just off-hand comments.”
Editing by Leslie Adler